Weighing the Impact of High Frequency Trading on Capital Markets: C.D. Howe Institute

TORONTO, Oct. 10, 2013 /CNW/ - High frequency trading is not the bane of capital markets that critics make it out to be, according to a report released today by the C.D. Howe Institute. In "High Frequency Traders: Angels or Devils?" author Jeffrey G. MacIntosh weighs the effects of lightening fast, automated trading on capital markets and finds that, overall, it is having beneficial effects.

High frequency trading is taking world capital markets by storm," says the author, "notably in the United States and the United Kingdom, where it accounted for about 50 percent of equities trading in 2012, and to a growing extent in other parts of Europe and in Canada. But are high frequency traders angels or devils in terms of the impact on capital markets? That is the question I address."

Critics claim high frequency trading (HFT) puts retail and institutional investors at a speed disadvantage. They also blame high frequency trading for the US "flash crash" of May 6, 2010 and say it has increased the likelihood of such events happening again.

After examining what HF traders do and how HFT differs from traditional market making, MacIntosh explores the empirical evidence relating to the effect of HFT on capital markets, and the policy issues that HFT raises.

He concludes that HFT enhances market quality. It lowers bid/ask spreads, reduces volatility, improves short-term price discovery, and helps create competitive pressures that reduce broker commissions. Retail traders, despite being at a speed disadvantage, realize a net gain from HF trading in the world's capital markets, says MacIntosh.

Macintosh provides recommendations to address the issues raised by HFT critics, including:

• Maintain the Order Protection Rule and Contain the Spread of Dark Pools: To prevent abusive trading practices, protect client interests, and create a level playing field among different trading venues, policymakers should defend the consolidated order book by maintaining and policing the order protection rule and minimizing the leakage of trading from the "lit" markets to "internalizers" and "dark pools."
  
  
• Do Not Interfere with Maker/Taker Pricing Models: Some observers say maker/taker pricing raises trading costs for retail traders, because retail trade orders are typically on the active side of the market, and associated fees are passed on to customers. However, it is likely that much or all of the increased cost that results from being on the active side of the market has been absorbed by retail brokers.  In addition, any increased cost that is passed on to the retail customer is more than made up for by lower bid/ask spreads on stocks.

Focus on Circuit Breakers to Prevent "Flash Crashes": HF traders did not cause the "flash crash," and are less likely than traditional market makers to withdraw liquidity supply when markets become volatile. Canadian regulators concerned with preventing similar events should focus on circuit breakers to stop market anomalies before they turn into "flash crashes," in addition to ensuring that liquidity is not drained out of the "lit" markets by internalizers and dark pools.

For the report go to: http://www.cdhowe.org/high-frequency-traders-angels-or-devils/23081

SOURCE: C.D. Howe Institute